How to calculate amortization with examples

Introduction

Amortization, in financial and accounting terms, involves spreading payments over multiple periods for loans or allocating the cost of intangible assets over their useful lives.

This article will explain the basic terms and show calculations and examples of different kinds of amortization.

This guide is also related to our articles on understanding journal entries in accounting, understanding prepaid expenses, and how to read a balance sheet.

This list includes:

• Amortization of loans
• Amortization of intangible assets
• Amortization schedule example
• Difference between amortization and depreciation
• Calculating amortization

Let’s dive in!

Definition and fundamental concepts

At its heart, amortization is about spreading out costs.

Think of it as slicing a cake; instead of eating it all at once, you enjoy a piece at a time.

For small business owners, this concept applies to loans and intangible assets. With loans, it means dividing your payments over the loan’s life, mixing in both the principal (the initial amount borrowed) and the interest. For intangible assets (like patents or trademarks), it spreads the cost over their useful life, reflecting their decreasing value on your balance sheet.

What are intangible assets?

Assets are the stuff your business owns. Tangible assets are things like equipment, furniture, vehicles and property. Stuff you can touch.

Intangible assets are, well, intangible. These are things like patents, copyrights, proprietary software you own, licensed material, trademarks, etc. They have value, but they’re not physical assets.

Why do we amortize intangible assets?

Amortizing the cost of intangible assets instead of letting them sit on the balance sheet forever helps in a few key ways:

Fair Financial Reporting: Intangible assets like patents or trademarks have a useful life — they don’t benefit your business indefinitely. Amortization allows you to spread the cost over the asset’s useful life, reflecting its decreasing value as it gets closer to the end of its usefulness.

Tax Efficiency: Amortization can reduce your taxable income each year, spreading out the tax benefits.

Compliance with Accounting Standards: Accounting rules generally require that intangible assets with finite lives be amortized. This ensures that financial statements are accurate and comparable over time and across companies.

So, by amortizing these assets, you align your financial reports with the actual value the assets bring to your business, comply with accounting rules, and manage your tax liabilities more effectively.

Amortization vs. depreciation

While these two terms may seem similar, they apply to different types of assets:

Amortization is for intangible assets. It’s how you gradually write off the initial cost of these assets over their useful life.

Depreciation is the counterpart for tangible assets. This includes physical things like machinery or vehicles, accounting for wear and tear over time.

Understanding the distinctions between these concepts is crucial because it affects how you manage your assets’ costs, impacting your financial statements and tax obligations.

Loans amortization

When you take out a loan, you don’t just pay back the amount you borrowed. There’s interest, too. Amortization is the process that spreads out your loan payments over time.

Each payment you make goes towards both the principal (the amount you borrowed) and the interest. At first, you’re paying more towards the interest.

But over time, as the principal decreases, you start paying more towards the principal and less towards the interest. This is good news because it means you’re working your way towards paying off what you borrowed, not just the interest.

Let’s make this practical and go over the process of loan vs. intangible asset amortization.

Loan amortization

When you amortize a loan, your early payments are mostly going towards interest, with a smaller portion reducing the principal. As time goes on, this ratio flips, and you start paying off more of the principal.

This progression is mapped out in an amortization schedule, a table that details each payment, showing how much goes to interest versus principal, and how the balance changes over time.

Step-by-step process for calculating amortization

• Know your loan details: You need the loan amount, the interest rate, and the term (how long you have to pay it back).
• Calculate your monthly interest rate: Divide your annual interest rate by 12 (the number of months in a year).
• Determine your monthly payment: This is where you’ll use an amortization formula or, more likely, an online calculator. The basic formula involves combining your loan amount, monthly interest rate, and the number of payments.
• Break down payments Into interest and principal: Initially, your payments will go more towards interest than principal. Over time, this flips.
• Create your amortization schedule: This schedule will list each payment, how much goes towards interest, how much towards the principal, and the remaining loan balance.

Here’s some examples of amortization calculations for different types of loans

Small business loan:

• Loan Amount: $50,000
• Interest Rate: 7% annually
• Term: 5 years

Using an online calculator, you’d find that you’ll pay 60 total monthly payments.

The monthly payment for this loan is about $990. Your first payment might include about $292 towards the principal and $698 towards interest.

By the final payment, those numbers flip, with almost all of the $990 going to the principal.

Commercial mortgage:

• Loan Amount: $200,000
• Interest Rate: 5% annually
• Term: 20 years

For a commercial mortgage, you’d have a total of 240 monthly payments. Your monthly payment would be around $1,300. Early on, around $800 of that might go to interest, with the rest towards the principal. As you approach the end of your term, the entire $1,300 would go to principal.

Each loan type might have its nuances, but the general principle of amortization remains the same.

Amortization of intangible assets

When it comes to the books, you can’t just lump the cost of acquiring intangible assets into one year’s expenses. Instead, you spread the cost over their useful life through amortization. Here’s how it works:

• Recognize the asset: When you acquire an intangible asset, record its cost as an asset on your balance sheet.
• Amortize over useful life: Divide the cost of the asset by its expected useful life to determine the annual amortization expense.
• Record the expense: Each year, decrease the value of the asset on your balance sheet by the amortization expense and record the expense on your income statement.

This process helps smooth out your expenses over time, giving you a more accurate picture of your business’s financial health.

Determining the useful life of an intangible asset

Figuring out how long an intangible asset will benefit your business can be tricky but it’s crucial for accurate amortization. Here are some tips:

• Legal life: For patents and copyrights, the legal protection period can guide you.
• Market life: How long will the asset be valuable in the market? For example, technology can become obsolete quickly.
• Contract life: If you have an asset like a lease or a license, the contract term might determine its useful life.

Make sure to review the useful life of your assets periodically. If the value or relevance of an asset changes significantly, you might need to adjust the amortization schedule accordingly.

Calculating the amortization of intangible assets is pretty straightforward. Here’s how to do it:

• Identify the cost: Pin down the purchase price of the intangible asset. Include any related expenses that brought the asset to its current condition and location.
• Estimate the useful life: Decide how many years the asset will benefit your business. This could be based on legal terms (like patents), contractual agreements, or your judgment.
• Calculate annual amortization: Divide the total cost by the estimated useful life. This gives you the annual amortization expense.

For example, if you’ve spent $20,000 on a software patent that you expect to use for 10 years, your annual amortization expense would be $2,000 ($20,000 / 10 years).

Amortization expenses in financial statements

Here’s how you reflect amortization on your books:

• On the balance sheet: Each year, reduce the book value of the intangible asset by the amortization expense.
• On the income statement: Record the annual amortization expense as a cost, which reduces your net income.

Effectively, this spreads the cost of the asset over its useful life, impacting your profit and loss statement annually.

Impact of amortization on valuation and profitability

Understanding the impact of amortization on your business is key. Here’s what it means for you:

• Valuation: Amortization charges can reduce your reported earnings, which might affect your business valuation in the short term. However, savvy investors and buyers will consider the long-term value of your intangible assets.
• Profitability: While amortization expenses reduce your net income on paper, they’re not cash expenses. This means your actual cash flow isn’t affected, even though your profitability appears lower. It’s important to communicate this to stakeholders who might be evaluating your business based on net income alone.

Practical tips and best practices

Navigating amortization doesn’t have to be a headache. Here’s a straightforward guide to keeping things in check.

Best practices for managing amortization

• Keep tabs: Regularly check your loan and asset schedules. This helps you stay ahead of payments and understand your financial position.
• Use tools: There are plenty of software options that can automate amortization calculations. Make use of them to keep your records accurate.
• Stay updated: Tax laws and financial regulations change. Keep your knowledge up to date to take advantage of any benefits or avoid penalties.

Tips for choosing loan structures

• Align terms: Choose loan terms that match the life of what you’re financing. Long-term assets? Consider a longer-term loan.
• Flexibility is key: Go for loans that let you make extra payments or pay off early without penalties. This can save you a lot of interest.
• Shop around: Don’t settle on the first loan offer. Compare rates and terms from different lenders to find the best deal.

Managing intangible asset investments

• Be conservative: When valuing intangible assets, it’s better to be cautious. Overestimating their worth can skew your financial picture.
• Invest wisely: Only invest in intangibles that directly contribute to your business growth or efficiency.
• Legal watch: Stay alert to any legal changes that might affect your intangibles, like copyright or patent laws.

Common pitfalls to avoid

• Interest ignorance: Don’t overlook how much of your early payments go towards interest. This understanding can influence your payment strategy.
• Tax overlooks: Missing out on tax deductions related to amortization can cost you. Keep a keen eye on this.
• Skipping early payment benefits: If your loan allows for it, making extra or early payments can cut down on interest significantly.
• Asset value misjudgment: Regularly reassess the value and useful life of your assets. Failing to adjust can lead to financial inaccuracies.

Conclusion

Stay sharp and keep up with the latest in amortization rules and practices. Laws and guidelines can change, and being in the know can save you from headaches during tax time or financial reviews.

In short, get comfortable with amortization; it’ll make your financial management smoother and more effective. Keep your business strategy sharp by integrating amortization into your financial planning and always be ready to adapt to new financial information.

Next, check out our articles on bank reconciliation examples, cash vs. accrual accounting, and what is a chart of accounts?

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Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly